Tuesday, March 7, 2017

JP Koning has written a thought-provoking post on the monetary system ("Money as layers"). (Based on the dozen or so posts I've read from him earlier, JP strikes me as a thoughtful, balanced writer who comes up with interesting, and often out-of-the-ordinary, topics. I've learned a lot from him. Johan, thanks for notifying me of this latest post of JP's!)

JP uses the layered structure of dreams from the film Inception as a metaphor for our monetary system. He says:

Like Inception, our monetary system is a layer upon a layer upon a layer. Anyone who withdraws cash at an ATM is 'kicking' back into the underlying central bank layer from the banking layer; depositing cash is like sedating oneself back into the overlying banking layer.

Monetary history a story of how these layers have evolved over time. The original bottom layer was comprised of gold and silver coins. On top this base, banks erected the banknote layer; bits of paper which could be redeemed with gold coin. The next layer to develop was the deposit layer; non-tangible book entries that could be transferred by order from one person to another. Bank customers could "kick" out of their deposits and back into banknotes, and then kick out of banknotes into coin. Conversely, they could sedate themselves from coin into notes and finally deposits.

(Note the terms 'sedate' and 'kick', as I'm going to use those when I build on JP's idea. 'Sedating' is moving further away from the bottom layer, while 'kicking' is moving towards the bottom layer.)

If we take reality to be the bottom layer in Inception, then it would make sense to have the bottom layer in our economy comprise of real goods and services. We can call it the real layer. JP only talks about the bottom, or foundation, layer of the monetary system – not the economy. To him that bottom layer used to be the precious metals (to me this is different from gold and/or silver coins, although JP seems to mix these together?) and is nowadays banknotes issued by the central bank.

I would place precious metals in bullion form on the real layer. Gold and silver coins, with a face value higher, or potentially higher, than the price of the metal itself (intrinsic value), used to form what I'd like to call a nominal layer ("credit layer" wouldn't probably be a bad name, either). Banknotes[1], deposits, etc, are all nominal layers.

So, we have the real layer and we have nominal layers. Just like dreams are connected to reality, so are the nominal layers connected to the real layer. As an anonymous reader said under JP's post: "People consider these subordinated assets to be claims on real commodity wealth". What provides this connection is the (nominal) price we set on goods and services when we trade them. It is the unit of account which forms a link between the real layer and any nominal layer (see my first post for how I view the unit of account).

Just like dreams can feel very real, so can nominal wealth feel very much like real wealth. And for a good reason: most of the time, an individual can convert nominal wealth into real wealth – that is, kick himself out of a nominal layer into the real layer. This can happen either directly, or indirectly via other nominal layers closer to the real layer than the starting layer.

Here the layer, or hierarchy, metaphor doesn't work that well: it is possible for an individual to kick out from many of the nominal layers directly into the real layer, without visiting any possible layers in-between. This, often but not always, means that the counterparty to the trade, the one who sells the good or the service, sedates from the real layer directly into that specific nominal layer, say, a commercial bank deposit. (An example of when this is not true: the credit entry on the seller's account brings the account balance to zero from a previous negative/debit balance (an overdraft). In that case it is hard for me to see how we could say that the seller ended up on that layer.)

Where JP isn't too clear is what is the quality, or qualities, that separates one layer from another. Does it have to do with the (perceived) riskiness of the layer, the institution behind the layer, or even with the chronological order in which the layers appeared, or seem to have appeared? As Johan Meriluoto points out (and JP confirms), this idea of layers is similar to Perry Mehrling's idea that "the system is hierarchical in character".

When it comes to what makes one layer different from another, Mehrling seems to focus on the institutions (although risk as a factor lurks always in the background). He gives an example of a simple hierarchy of a central bank, commercial banks and security dealers. Mehrling's hierarchy fluctuates: one hierarchical level, or layer, can look (qualitatively) much like another in good times, while under market stress the hierarchical character gets amplified. Thus, in what way and to what extent the layers (are perceived to) differ from each other varies with time.

It would be hard to argue that the layers are only about risk. A commercial bank deposit which is covered by a public deposit guarantee can arguably be viewed as being, at all times, on par with currency. And when JP suggests that a (private) deposit is somehow a subordinated layer compared to a (private) banknote, riskiness as a differentiating factor disappears entirely from the picture – after all, the risk of theft or misplacement makes a banknote less secure than a deposit.

When it comes to this question of priority between banknotes and what he calls "non-tangible book entries", I find myself at odds with JP. What he says makes some sense if we consider the recent history of banking as it applies to the general public (say, from the 18th century onward), but I'm not at all convinced it is true about the early history of monetary systems (which is, unfortunately, not known). What makes it untrue even if we only consider the recent history is that the book entries have existed, all of the time, side by side with banknotes. They were not the "next layer to develop" after banknotes.

That might very well be a minor detail for JP. What makes it somewhat important for me is that as I'm trying to build a monetary system from scratch (as it might have happened thousands of years ago, although I'm not trying to make a historical argument; this is a thought-experiment which I believe can help us understand the current system better), I find it makes sense to view/describe/understand banknotes in terms of the non-tangible book entries. The latter should be logically prior to the former. (You might get a better idea of what I mean by this if you read first Part 3 and Part 4, and then Part 7 of my series.)